When asked if management’s role is important in the investment process, Michael Mauboussin responded with what he called a “qualified, but emphatic, yes.”
He added that short-term investors, or speculators, can ignore what management does and how well it does it. However, “In the long term, management actions are much more likely to leave a lasting imprint on a company’s performance, and hence its stock price.”
In chapter nine of his book, "More Than You Know: Finding Financial Wisdom in Unconventional Places," he explained that he scrutinizes three aspects of management: leadership, incentives and capital allocation skills.
Leadership
Mauboussin considers the following three qualities to be the most important in a senior manager or CEO:
- Learning: The author wanted to see “a consistent thirst to learn,” an intellectual curiosity and an ability to consider contradictory ideas. He also wanted managers to truly want to know what’s happening within their organization, which in turns means listening to employees, customers and others. It means providing an environment within which everyone in the organization can speak out without fear of repercussions.
- Teaching: For Mauboussin, teaching is the ability to communicate a simple and clear vision to the organization. It also requires a balance between constantly repeating a core message and adapting the message when circumstances change. Leaders who have a passion for their business have an inherent advantage; they love to go to work.
- Self-Awareness: Finding that right balance between self-confidence and humility is difficult but essential. Self-confidence means knowing that with your own knowledge and the help of others you can make good decisions. Humility means recognizing that no one has all the answers. Smart executives will try to offset their shortcomings by hiring the right people.
Incentives
Economics has helped us understand the link between incentives and behavior. According to Mauboussin, “Long-term investors must go beyond typical managerial platitudes and understand what truly motivates management. The proxy statement may be the least read, and most important, public filing.”
This may be the first time I’ve seen an expert recommend a proxy statement, and he has a good point. A proxy statement must be issued before every annual meeting, and it details the biographies, compensation and other details about senior management and those who hope to become directors.
Thus, savvy investors will check out the people who are running or will run the companies in which they’ve invested. They will pay attention to the incentives, which may include stock options or restricted stock. Speaking of options, Mauboussin did not like them being offerred as an incentive:
“Take employee stock options. A strong argument can be made that typical option programs do not provide employees with appropriate incentives. Specifically, in bull markets, all option holders stand to benefit, and in bear markets, all suffer, without any clear distinction between companies that deliver superior performance and those that don’t. Throw in option repricing (heads I win, tails you lose) and muddled thinking about option accounting, and it’s not hard to see why options never satisfied the incentive question.”
Nor is he a fan of restricted stock. “If grants are not clearly tied to economic performance, and grant recipients are not in a position to influence the stock price (the majority of employees), then how are stock grants acting as an appropriate incentive?”
What he would like to see are incentives that link to some aspect of the business each employ can control. In turn, that means aligning incentives throughout the firm with the appropriate value drivers.
Then, there’s the issue of accounting earnings versus economic performance. Mauboussin noted that there is a significant risk of agency costs when management focuses on accounting earnings. "You want managers who, when facing a choice between adding to accounting earnings or economic value, always opt for value.”
Capital allocation
In Mauboussin's words, “All roads in managerial evaluation lead to capital allocation.” His definition of capital allocation is the process of directing the firm’s resources in a way that will optimize long-term returns in excess of the cost of capital.
He starts his assessments of capital allocation with a look at the firm’s history. How has management allocated capital in the past? Has it generated sufficient returns? There may be answers in historical data. “Past capital allocation often provides a good indication of the business’s capital appetite and often reveals management’s focus and preferences.”
Mauboussin also cast a skeptical eye on mergers and acquisitions. While selling shareholders usually do well, the same can’t be said for the buyers. Why? Because acquiring shareholders are likely to have paid a premium that is greater than the present values of the synergies the merger or acquisition might provide.
He added, “Reversion to the mean is the microeconomic equivalent of the grim reaper: all high-return companies succumb to it sooner or later (great managers make it later). Significant M&A activity almost always suggests a company’s returns are gravitating to the cost of capital.”
Finally, the author discussed human capital allocation,
“Does management understand how to put the right people into the right jobs? Too often companies seek to promote executives with the 'right stuff'—good communication skills, smarts, and success in a specific context—without full consideration of their actual work skills and experience. As a result, these companies misallocate human capital, with poor results for both the business and the executive.”
Conclusion
Management is a crucial variable for long-term investors; for short-term investors, the skill of management matters much less.
Michael Mauboussin focused on three primary issues when assessing management: leadership, incentives and capital allocation. Within each of these issues he drills deeper to make his analysis more granular and comprehensive.
Over the longer term, a skilled and passionate manager is more likely to take actions that lead to better returns.
Read more here:
- More Than You Know: The Myopic Loss Aversion Problem
- More Than You Know: What's Behind Investing Hot Streaks?
- More Than You Know: Experts and the Issues They Confront”‹
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
